Gold stocks have
recovered sharply following last month’s panic-like capitulation
plunge. But this embattled sector still remains incredibly cheap
relative to prevailing gold levels, which drive gold miners’ profits
and hence ultimately their stock prices. While it is very
challenging psychologically to buy in deeply-out-of-favor sectors,
the panic-like gold-stock bargains out there today are simply
amazing.

Speculators and
investors have long bought gold stocks for one primary reason, to
leverage the price of gold. Between the April-2001 dawn of today’s
secular gold bull and 2008’s once-in-a-lifetime stock panic, gold
stocks indeed leveraged gold beautifully. When gold rallied in
major uplegs, the flagship HUI gold-stock index would generally
amplify this metal’s gains by
at least 2x to 3x.
It was wildly profitable.

But unfortunately
that epic stock panic, a perfect storm of fear, broke this normal
and well-established bull-market relationship. Most of the
pre-panic gold-stock traders couldn’t handle the extreme stress of
the panic, which drove the HUI to plummet 68% in less than 3.5
months. The psychological damage that event wreaked was vast beyond
imagining, scaring away an entire generation of gold-stock
investors.

But of course the
worst time to sell is when you most want to, when things look the
bleakest. That is when prices are as low as they’re going to get.
So I advised our subscribers to
buy gold stocks
aggressively in the dark heart of the stock panic, when all hope was
lost. And indeed they recovered sharply. By September 2011, the
HUI had more than quadrupled to dazzling new all-time highs!

This performance
was mind-boggling by any standard. Over this same 34-month time
frame, the general stock markets as reflected by the S&P 500 merely
rallied 40%. Commodities as a group measured by the CCI more than
doubled this with an 83% gain. And gold’s 155% surge dwarfed them
all. But all these pale in comparison to the monster 319% HUI run
birthed deep in the panic’s fear maelstrom.

So the stock panic
definitely didn’t kill gold stocks, they’ve shown incredible
strength since. But it did frighten away a large fraction, maybe
even the majority, of pre-panic gold-stock speculators and
investors. And since it takes years for new traders to rise up and
replace the fallen, the gold stocks haven’t made anywhere near as
much headway as they should have given the high prevailing gold
prices since.

In the first half
of 2008, before that stock panic’s epic discontinuities hit, gold
averaged $911 on close. By the last half of 2011, this number
surged 86% to $1695. But meanwhile the average HUI close only rose
from 443 to 559, up 26%. The gold stocks have lagged gold’s
progress dramatically in this post-panic era, gaining less than
1/6th of their historical minimum baseline leverage of 2x gold’s
advance.

This great
divergence naturally continues to vex traders, who wonder if it is a
temporary anomaly or the new normal. The answer likely lies in
profits. Universally in the stock markets, profits drive
long-term stock prices. The more a stock or sector can earn, the
more investors will bid it up to reflect higher earnings streams.
Stock ownership is ultimately just a fractional stake in companies’
profits.

In gold mining,
profits are overwhelmingly dependent on the price of gold. The more
these miners can sell their product for, the higher their profits
rise. So if today’s higher prevailing gold prices are translating
into proportionally-higher profits, then gold stocks are
radically undervalued relative to the price of gold. And indeed
this is the case, as we’ve extensively researched
gold-mining
profitability as a whole.

Impressively,
between 2008 and 2011 average gold-mining profits soared 108% from
$440 per ounce to $915 per ounce! And the actual gross margins grew
too, from 50% in that panic year to 58% last year. So while
gold-mining costs are indeed rising as gold-stock bears love to
point out, profits are growing much faster. Thus the gold stocks
will ultimately have to be bid up to reflect higher
prevailing gold prices.

Just how cheap are
gold stocks today? My favorite metric for exploring this is the
venerable HUI/Gold Ratio. The HGR simply divides the daily close of
the HUI gold-stock index by gold’s own. When charted over time,
this basic ratio reveals trends in the relative performances of gold
stocks and gold. A rising HGR shows gold stocks outperforming gold,
while a falling one shows the miners lagging their metal.

I’ve updated this
chart every few months since the stock panic, because its
implications for gold stocks are wildly bullish. In it the blue HGR
line is superimposed over the raw HUI in red. Of course the panic’s
impact on gold stocks was massive beyond belief, so that epic
discontinuity abruptly divides gold-stock performance. Normal
secular-gold-bull gold-stock behavior was seen for many years before
the panic.

Between the middle
of 2003 and the middle of 2008, just before the stock panic, the HGR
trended sideways in a tight secular trading range between 0.46x and
0.56x. Both upside and downside breakouts were rare and
short-lived. The 5-year pre-panic-average HGR weighed in at
0.511x. In other words, gold stocks as measured by the HUI tended
to trade around half the prevailing gold price at any time.

While the panic
understandably terrified everyone, there was no reason why gold
stocks shouldn’t have soon recovered to pre-panic levels. And
indeed this happened in the raw HUI itself. By December 2009, just
13 months after the panic lows, the HUI was back up near its March
2008 all-time highs. And gold stocks continued powering higher from
there on balance, hitting new record highs in 2010 and 2011.

But relative to
gold, the product that drives gold miners’ profits and hence
ultimately stock prices, the gold stocks weren’t doing anywhere near
as well after the panic. Following an initial fast recovery in
2009, the HGR stalled out and stabilized in 2010. But it was still
low relative to its pre-panic average, not even into that secular
trading range yet. At the time it looked like the HUI was basing
ahead of a catch-up surge.

But unfortunately
last spring the HGR started breaking down again. It wasn’t because
gold stocks were falling, they were holding their own near
all-time highs. But the price of gold was surging on US
debt-default fears and the gold stocks weren’t following. A
rare summer rally
catapulted gold to huge gains, but the gold stocks failed to
leverage them. So the fragile confidence in this sector quickly
eroded.

When the
overbought gold
price corrected last autumn, the gold stocks got sucked in like
usual even though they didn’t participate in gold’s preceding
surge. But the HUI soon found major support near 500, and stood
strong as gold continued lower. But a sharp commodities selloff in
March 2012 on the latest
no-QE3 scare
was too much to for gold-stock traders to bear psychologically, so
they sold aggressively.

This snowballed
into a rare
full-blown capitulation, which climaxed at extreme levels in
mid-May. The sharp plunge in the HUI and collapse in the HGR are
readily apparent on this chart. Gold stocks were driven back down
to panic levels relative to the price of gold! So naturally
sentiment was utterly rotten, nearly as hyper-bearish as it had been
in the stock panic’s dark heart. It felt like a bloodbath.

On May 15th, the
HUI/Gold Ratio actually closed at 0.244x! To give you an idea of
how extreme this is, the HGR only closed below 0.25x on 10 separate
trading days during the entire stock panic. Last month was only the
second time such incredibly-low levels were seen in this entire
secular gold-stock bull, which is over 11 years old now. Gold
stocks were truly trading at panic levels relative to gold last
month!

Of course such
valuations for gold stocks were absurd fundamentally. The
HUI closed at 376 when the capitulation bottomed. The first time
this index hit 375 in this bull was in April 2006 when gold had just
exceeded $625. But the HUI couldn’t sustain 375 until over a year
later in September 2007 when gold first crossed $725. Yet in
mid-May 2012 when the HUI fell to 375 again, gold was trading near
$1550!

With gold over
twice as high and gold-stock profits massively higher, there was
zero fundamental justification for this gold-stock capitulation. It
was purely a psychological event. The gold-stock traders foolishly
allowed themselves to get so scared that they battered down the gold
stocks to trade as if gold was in the $700s. Thankfully
sentiment-driven extremes never persist, fear quickly burns itself
out.

Indeed gold stocks
have already started bouncing back sharply, as is evident in both
the HUI and HGR. But there is almost certainly a long way to go yet
in both absolute terms and relative to gold. After similar extreme
lows in the stock panic, the HUI soon regained its pre-panic highs.
A comparable recovery today would push the HUI back up to September
2011’s 635 within 13 months of May’s low, by next spring.

But gold stocks’
likely performance relative to gold is far more interesting.
Absolute worst case, the HUI should soon mean revert to its
post-panic average HGR which ran 0.358x. Assuming gold does
nothing, just drifts around $1600 listlessly, this implies a HUI
around 573 by autumn. This ultra-conservative assumption yields a
projected gain of 28% in the HUI, which smaller gold stocks will
greatly leverage.

After such a rare
fear extreme as May’s capitulation, I suspect a higher-probability
rally in HGR terms is back up near the top of its post-panic
trading range. Once sentiment gets dragged too far in one
direction, it tends to rebound back to the opposite extreme before
stabilizing. At September 2009’s 0.437x HGR, we would be looking at
a 699 HUI if the gold price stayed flatlined. This is a huge 56%
gain from today!

But our ongoing
research into
gold-mining profit levels makes me much more optimistic than
merely thinking in post-panic terms. Gold miners are earning money
hand over fist, doing incredibly well. So their price-to-earnings
ratios are falling like stones, and sooner or later big
institutional contrarian value investors will take notice. So I
still fully expect to see the pre-panic average HGR of 0.511x
regained.

What would
gold-stock prices look like in this scenario? This next chart zooms
in to see. In addition to the HGR in blue and the raw HUI in red, I
added a third series in yellow which is where the HUI would be
hypothetically trading at its pre-panic average HGR of 0.511x.
While it may seem wildly optimistic given today’s rampant gold-stock
bearishness, such valuations would not be a stretch at all
fundamentally.

As this yellow
hypothetical-HUI line reveals, today’s $1600ish gold would support a
HUI level near 818! This is about 83% higher than today’s
gold-stock price levels, a mammoth gain by any standard. In
addition to the fundamental profit support for this thesis, the
post-panic example of the HGR rebounding sharply after lows not much
more extreme than May’s also argues this is beyond possible to
probable.

The recent
gold-stock capitulation that drove the HUI/Gold Ratio collapse
hammered the actual HUI to its lowest levels relative to the
hypothetical HUI since the stock panic. It was merely at 48% of
where a 0.511x HGR would have put it, compared to reads at major
interim lows and highs since the panic ranging from 61% to 82%. So
even by post-panic standards, gold stocks are ridiculously cheap
today.

And the recovery
rally has already started, just as I predicted it would right after
May’s capitulation.
As of early June the HUI had surged 21.0% out of those extreme lows
over a time frame where gold was only up 4.9%. As this momentum
builds and more and more speculators and investors realize how
radically undervalued gold stocks are, this rally will only
accelerate. It will probably mirror 2009’s gigantic surge.

While it may seem
like there is no way we’ll ever see pre-panic HGR levels again,
consider silver’s example. It too had a
pre-panic
relationship with gold that was shattered in the stock panic.
And it too looked like it would never return to pre-panic levels
relative to gold. But silver eventually won a broad trader
following again, and in
late 2010 and
early 2011 new capital flooded into this forsaken metal.

So not only did
silver regain its pre-panic levels relative to gold, it greatly
exceeded them in the spring of 2011! And even this week, with
silver almost as out of favor as gold stocks, it is still trading
right around its pre-panic average relative to gold again. Sooner
or later some catalyst will come along that will explosively
reignite interest in the abandoned gold-stock sector, and capital
will return with a vengeance.

I suspect it will
simply be a rallying gold price. As you know, with the mess in
Europe and crucial US elections looming this year, we face an
environment riddled with intense uncertainty. Anxiety is
only going to grow into early November, and possibly even into early
2013 as we wait to see how the new Congress will act. Gold is going
to look increasingly appealing as the future remains terribly
opaque.

And of course a
new gold upleg ratchets up the gold-stock price projections
based on the HUI/Gold Ratio accordingly. All of them here use the
conservative (and unrealistic) assumption that gold will merely
drift sideways around today’s $1600 level. If it heads up over
$2000, which a surprisingly number of elite research houses are
predicting for later this year, all the HGR-based HUI projections
rise 25% as well.

It’s also
important to remember that the giant slow-moving gold miners
naturally dominate the HUI. A major gold and gold-stock upleg would
translate into smaller high-potential gold stocks, both elite junior
explorers and small producers, leveraging the HUI’s gains by
several times or more. So the opportunities in quality smaller gold
stocks today for hardened contrarians who can handle the stress are
tremendous.

Over the past
decade we and our subscribers have earned fortunes trading the best
stocks in the vast junior-gold realm. So we are constantly
researching the many hundreds of publicly-traded junior
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The bottom line is
gold stocks are incredibly cheap relative to prevailing gold
prices. Last month’s capitulation by scared traders hammered gold
stocks to their worst levels relative to gold since 2008’s
once-in-a-lifetime stock panic. After that earlier extreme, gold
stocks rocketed higher to regain some fundamental balance with the
metal that drives their profits. A similar rebound is now due
again.

Even to merely
regain post-panic-average levels relative to gold, the major gold
stocks would have to surge dramatically higher. But with
gold-mining profits hitting new records, fundamentals certainly
support the far-more-optimistic pre-panic levels. With this rebound
rally so young, brave contrarians have a heck of an opportunity to
capitalize on this short-lived anomaly and buy today’s cheap gold
stocks.